New report shows UK banks still sickly, 10 years on from run on Northern Rock

Latest round of Bank of England stress tests drastically underestimates vulnerability of UK banking system and risks to the UK economy

UK banks remain highly leveraged; a 2007-08 level shock could still cause the banking system to collapse

Properly stringent stress tests and market valuations of bank capital would have seen all major UK banks fail

Bank of England’s stress tests are worse than useless – offering false comfort while herding banks into identical business models

The British banking system is an ‘accident waiting to happen’ according to a new report released today by the Adam Smith Institute, ten years after the run on Northern Rock heralded the beginning of the financial crisis.

Kevin Dowd, author of the report and professor of finance and economics at Durham University, says the Bank of England’s stress tests continue to greatly overstate the financial resilience of the UK banking system.

High bank leverage was a key contributing factor to the severity of the financial crisis and UK banks are still highly leveraged, but easy-to-game risk weighting measures still hide this.

The Bank of England’s stress tests look at book-values – values of assets and securities recorded in accounts. On these measurements UK banks’ leverage fell by around a third since 2006. Using more accurate numbers based on real market value reveals that banks’ leverage has actually increased by about a half.

Market-valuations of bank capital are more reliable than book valuations, says the report, indicating that markets believe banks are still carrying large hidden losses not reflected in book valuations or in the stress tests. By doing so, the report suggests, the stress tests provide the public with false assurance about the financial health of their banks.

UK banks experienced losses of around half a trillion pounds from the last crisis. The Bank of England, as recently as last month, suggested from its view that British banks were in a far better shape to cope with a major shock than they were ahead of the last recession. The paper argues that this is not the case and another crisis on a similar scale could wipe out the entire capital of the banking system multiple times over.

The Bank’s stress tests are seriously flawed in a number of respects, Prof Dowd shows:

they are based on book values instead of market values,

pass standards are based on minimum capital requirements that are way too low,

they generate implausibly low losses for a severe stress,

they are based on discredited and gameable metrics such as Risk-Weighted Assets and Tier 1 capital (which include OECD government debts - including eurozone crisis countries such as Italy), and

they fail to even consider some of the biggest risks faced by the UK banking system.

Professor Dowd suggests that the stress test programme is so severely compromised that it should be scrapped. Instead, the Bank of England should focus on the reforms really needed to get the UK banking system on its feet – raising capital standards, and establishing tighter corporate governance and reforming accounting standards.

Another shock on the scale of 2007-08 is a possibility, something the tests are designed to prepare for, but UK banks and the Bank of England are not remotely ready for it. Instead, the report argues, the Bank’s policies towards the banking system amount to a form of Russian roulette risking disastrous consequences for the UK economy.

Kevin Dowd, senior fellow of the Adam Smith Institute and author of the report, said:

“The stress tests are about as useful as a cancer test that cannot detect cancer. They seek to demonstrate a financial resilience on the part of UK banks that simply isn’t there.

"It is disturbing that 10 years on from Northern Rock, the best measures of leverage – those based on market values – indicate that UK banks are even more leveraged than they were then.

"The biggest risk facing the UK banking system now is the Bank of England’s own complacency.”

Ben Southwood, Head of Research at the Adam Smith Institute, said:

“The Bank of England, understandably, wants to prepare for bad eventualities. But its definitions of risk are nonsensical—Italian sovereign debt counts as zero-risk—and easy to game. That means that the stress tests are yet another incentive for banks to put all their eggs in one basket. Even if the Bank were right about risks, this would make crises less frequent, but when they did arrive, much, much worse.

“The Bank of England, now with all its extra powers, should focus on improving the rules of the game, not micromanaging banks’ balance sheets.”

Notes to editors:

For further comments or to arrange an interview, contact Matt Kilcoyne, Head of Communications, matt@adamsmith.org | 07584 778207. A full version of the report "No Stress III – The flaws in the Bank of England’s 2016 stress tests" can be found here.